Professional Documents
Culture Documents
2d 1255
65 A.F.T.R.2d 90-833, 58 USLW 2552, 90-1
USTC P 50,151
This opinion addresses cross appeals by the United States and Internal Revenue
Service Special Agent Robert Hackett, and by Rockwell International
Corporation, from an order of the district court granting in part and denying in
Although we would hesitate to conclude that the district court's finding as to the
scope of the investigation was clearly erroneous as a matter of fact, we find
legal error in the method employed by the district court in reaching its
conclusion. More specifically, the district court erred by ignoring the
overarching institutional purpose of the IRS, and by making its decision solely
on the basis of a single agent's statements. Under United States v. LaSalle Nat'l
Bank, 437 U.S. 298, 98 S.Ct. 2357, 57 L.Ed.2d 221 (1978), the government's
good (or bad) faith in pursuit of its investigation must be measured against the
institutional purpose, which the IRS represents to be an investigation into the
correctness of the entire 1983 return. Consequently, we will remand for the
district court to determine whether the free reserve file is relevant not merely to
the Chattanooga plant closing, but to the 1983 Rockwell tax return as a whole.
5
If the district court concludes that none of the material in the free-reserve file
pertains to the 1983 tax return, that determination would appear to end the
matter. However, if some of the material in the file is found to be relevant, the
district court will have to address Rockwell's contention that the free reserve
file was protected from disclosure by the attorney-client privilege or the work
product doctrine.
Although we affirm in part, for the reasons stated the order of the district court
must be vacated and the case remanded for further proceedings consistent with
this opinion.
In the course of conducting its routine annual audit of Rockwell, the Internal
Revenue Service stumbled across a memorandum, authored by Rockwell tax
accountant Joseph Vitullo, which suggested that Rockwell had understated
income on its 1983 tax return by approximately 13 million dollars by
incorrectly reporting income derived from the closing of Rockwell's plant in
Chattanooga, Tennessee. The memorandum also noted that documentation of
the mistake could be found in Rockwell's "free reserve file."1
10
13
Maintenance of the free reserve file allows Rockwell to calculate its contingent
future tax liability by analyzing "those areas in which the taxpayer has taken a
position that may, upon challenge, negotiation, or litigation, require the
payment of more taxes." United States v. El Paso Co., 682 F.2d 530, 534 (5th
Cir.1982), cert. denied, 466 U.S. 944, 104 S.Ct. 1927, 80 L.Ed.2d 473 (1984),
see also United States v. Arthur Young & Co., 465 U.S. 805, 813, 104 S.Ct.
1495, 79 L.Ed.2d 826 (1984); supra note 1. These calculations are required
both by generally accepted accounting principles and by Securities and
Exchange Commission regulations. App. at 80, 82-83.
14
In many cases, such files are prepared by accountants (both in-house and
otherwise). Preparation thus does not always require consultation with an
attorney. See El Paso, 682 F.2d at 534-35. In Rockwell's case, however, Charles
C. Stoops, Jr., an attorney who serves as Rockwell's General Tax Counsel,
testified that he maintains the file himself, with the assistance of attorneys and
accountants acting under his direct supervision. The file is kept in Stoops's
office and it may not be inspected without his permission. App. at 67. Stoops
testified that, in addition to the calculations mentioned above, the file contains
his mental impressions as to settlement positions, litigation strategy, and
interpretation of trends in the tax law. Id. at 35-36. Rockwell employed the
independent accounting firm of Deloitte, Haskins and Sells to serve as its
outside auditors. According to Stoops, he has never surrendered the file to
outside auditors, although he has discussed with them some of the contents of
the file for purposes of estimating liability and exposure. Id. at 43-44.
15
16
17
There
are two of us assigned to this investigation, and the information, as I
understand it, is available by summons, and it is my feeling that both of us should
see the information so that we can discuss it and properly analyze it.
18
Id. at 116.
19
Faced with Rockwell's refusal to produce the free reserve file on the IRS's
terms, the government, on March 9, 1988, filed a petition in the district court
for the Western District of Pennsylvania to enforce the summons. The petition
was supported by Agent Hackett's affidavit, which stated that the IRS was
investigating the possibility of criminal violations surrounding Rockwell's
income taxes for the fiscal year ending September 30, 1983. Id. at 11. Rockwell
defended on the grounds that the free reserve file contained nothing relevant to
the Chattanooga plant closing, and that, even if it did, the documents would be
protected by the work product doctrine and the attorney-client privilege.
20
After a hearing on the petition to enforce the summons, the district court, in a
memorandum dated October 21, 1988, summarily rejected Rockwell's privilege
arguments, and entered an order instructing Rockwell to pay an independent
auditor (chosen by the IRS), to determine which, if any, documents in the free
reserve file are relevant to the plant closing, and hence accessible by the
government. The lion's share of the district court's holdings can be found in
three short paragraphs. They read as follows:
21
The Fifth Circuit has ruled on the vulnerability of a tax contingency file to an
21
The Fifth Circuit has ruled on the vulnerability of a tax contingency file to an
IRS summons. In United States v. El Paso, 682 F.2d 530 (5th Cir.1982), the
court entertained a motion to enforce a summons for the tax pool analysis and
supporting memoranda (the equivalent of the free reserve file). The court held
that the information in the file was relevant, Id. at 537, and that the file was not
shielded by the attorney-client privilege, Id. at 539-41, or the work-product
privilege, Id. at 542-44.
22
In light of the Fifth Circuit's finding in El Paso, we find that the IRS is entitled
to access to relevant portions of the free reserve file. In El Paso, the IRS was
conducting an investigation into El Paso Co.'s tax returns for 1976-1978.
Consequently, the court ordered El Paso Co. to surrender the tax pool files for
those years. In this case, the IRS is conducting an investigation into the closing
of the Chattanooga plant, not Rockwell's entire tax returns for the relevant
period of time. Therefore, it seems to this court that the IRS is entitled to access
to the portions of the free reserve file relating to the closing of the Chattanooga
plant.
23
Rockwell has offered to pay the expenses for an independent auditor to examine
the free reserve files and separate any materials relating to the closing of the
Chattanooga plant. This solution seems fair to this court, so we will order the
IRS to select an independent accounting firm and Rockwell to pay the firm's
fee.
24
Id. at 205-06. It is this order from which the government and Agent Hackett
appeal, and Rockwell cross-appeals.
26
27
With respect to Rockwell's first point, we think it clear that the harm to the
government arises not from eventually being deprived of certain documents, but
in being required to submit to the third-party relevancy determination in the
first place. As we explain below, the government is entitled to have the court
determine relevance. Whatever the independent accounting firm might decide,
the government has been harmed by the district court's improper decision to
delegate its judicial authority. On appeal, the government is asserting its right
to have the district court determine relevancy. It need not await the outcome of
the independent accounting firm's determinations before asserting that right.
28
Rockwell's second contention is that the order is not final because if the IRS is
not satisfied with the accounting firm's results, the IRS can return to the district
court for further proceedings. This argument is unpersuasive. An examination
of the record reveals that the district court's order was intended to be its last
words on the matter. The court's order does not contemplate further
proceedings; rather, it states unequivocally that Rockwell "shall surrender to
the Internal Revenue Service all materials determined by the accounting firm to
relate to the closing of the Chattanooga plant." App. at 207. It is clear that the
district court's decision was "a final judgment on the merits of the only matter
before the court--the petition to enforce the summons--and there was nothing
left for the court to do but execute the judgment." United States v. Allee, 888
F.2d 208, 212 (1st Cir.1989) (per curiam) (emphasis in original); see also
Reisman v. Caplin, 375 U.S. 440, 449, 84 S.Ct. 508, 513, 11 L.Ed.2d 459
(1964) (orders of a district court judge enforcing a section 7602 summons are
appealable). For a more narrow reading of Reisman, see Steinert v. United
States, 571 F.2d 1105, 1107 (9th Cir.1978). We therefore find the appeal of the
district court's order to be properly before us.
Turning to the merits of the district court's decision, we are faced with three
questions: (1) whether the district court properly conditioned enforcement of
the summons upon a determination of its relevance to the Chattanooga plant
closing, (2) whether the district court properly delegated that determination to a
private accounting firm, and (3) whether the district court erred in rejecting
Rockwell's invocation of the work product doctrine and the attorney-client
privilege. Although analysis of these issues necessarily involves some overlap,
we shall attempt to discuss them discretely.
31
32
conditionally has been debated in the courts of appeals, with divergent results.
Compare United States v. Author Servs., 804 F.2d 1520 (9th Cir.1986),
modified, 811 F.2d 1264 (1987) with United States v. Barrett, 837 F.2d 1341
(5th Cir.1988), (en banc) (per curiam), cert. denied, --- U.S. ----, 109 S.Ct.
3264, 106 L.Ed.2d 609 (1989). The Supreme Court recently faced the issue in
United States v. Zolin, --- U.S. ----, 109 S.Ct. 2619, 105 L.Ed.2d 469 (1989),
but was evenly divided over a Ninth Circuit ruling that such summonses could
be enforced conditionally to protect against abuse of a court's process. See id. at
2625; Zolin, 809 F.2d 1411, 1417 (9th Cir.1987).
33
34
When the IRS summoned Rockwell, it did so pursuant to 26 U.S.C. Sec. 7602,
which provides, in relevant part, as follows:
40
The proper focus of such proceedings was described in Powell, which sets forth
a four-step prima facie showing that the government must make before a
summons can be enforced. Powell requires the government to
Powell, 379 U.S. at 57-58, 85 S.Ct. at 254-55. However, this showing does not
automatically entitle the government to enforcement of the summons. The
taxpayer retains the right to "challenge the summons on any appropriate
ground." Id. at 58, 85 S.Ct. at 255 (quoting Reisman v. Caplin, 375 U.S. 440,
449, 84 S.Ct. 508, 513, 11 L.Ed.2d 459 (1964)). The teaching of subsequent
decisions is that an "appropriate ground" for challenging the summons exists
when the taxpayer disproves one of the four elements of the government's
Powell showing, or otherwise demonstrates that enforcement of the summons
will result in an abuse of the court's process. See Barrett, 837 F.2d at 1350;
United States v. El Paso Co., 682 F.2d 530, 536-37 (5th Cir.1982).
43
In the case at bar, the government satisfied its Powell burden by filing a petition
to enforce the summons accompanied by the sworn affidavit of Special Agent
Hackett. Rockwell defended against the summons by alleging bad faith
investigation by the IRS and lack of relevancy, and by invoking the attorneyclient privilege and the work product doctrine. Because Rockwell has not
pursued the bad faith issue in its cross appeal, we turn to the question of
relevance.4
44
The district court ruled that "the IRS is entitled to access to the portions of the
free reserve file relating to the closing of the Chattanooga plant." App. at 206.
Rockwell asserts that this ruling was correct. The IRS argues that it should be
entitled to review the entire free reserve file for the tax years involved, and that
the district court improperly restricted its access. In support of its position, the
government argues that the district court erred by ignoring the "institutional
purpose" of the IRS and by relying on the statements of a single IRS agent to
determine that the IRS was "conducting an investigation into the closing of the
Chattanooga plant, not Rockwell's entire tax returns for the relevant period of
time." The key to this issue is the IRS's "legitimate purpose." Apparently, the
district court determined that the IRS's purpose (under the Powell analysis) is
an investigation of the Chattanooga plant closing only. This determination was
legally incorrect.
45
The cases decided since Powell have shown that the requirement of legitimate
purpose means nothing more than that the government's summons must be
issued in good faith pursuant to one of the powers granted under 26 U.S.C. Sec.
7602. See, e.g., United States v. Bisceglia, 420 U.S. 141, 146-47, 95 S.Ct. 915,
919, 43 L.Ed.2d 88 (1975) ("Once a summons is challenged it must be
scrutinized by a court to determine whether it seeks information relevant to a
legitimate investigative purpose and is not meant 'to harass the taxpayer or to
put pressure on him to settle a collateral dispute, or for any other purpose
reflecting on the good faith of the particular investigation.' " (citation omitted));
United States v. Coopers & Lybrand, 550 F.2d 615, 620 (10th Cir.1977)
(quoting Bisceglia); see also El Paso, 682 F.2d at 546-47 (Garwood, J.,
dissenting) ("Accordingly, 'such inquiry' or 'such question' is properly
understood as referring to the question of 'the correctness of any return' or 'the
liability of any person for any internal revenue tax.' " (quoting 26 U.S.C. Sec.
7602(a))). We find no case requiring the government to delineate a specific and
narrow purpose, and then holding that the summons will be enforced only
insofar as it is relevant to that purpose. Indeed, the cases discuss not what the
actual purpose is, but whether the summons was issued in good faith pursuant
to a legitimate investigation--that is, an investigation authorized by section
7602.
46
47
memorandum and the Chattanooga plant closing are properly understood not as
evidence of a specific purpose, but as evidence of the government's good faith
and "legitimacy" in pursuing its institutional purpose--the investigation of the
correctness of returns. Because the government's purpose is the investigation of
the correctness of the 1983 return, we will remand to the district court with
instructions to determine the relevance of material in the free reserve file to this
purpose. In making this determination, the district court should be guided by
the body of case law which has defined the rather liberal standard of relevance
in section 7602. Under this section, the government is entitled even to
information that has only "potential relevance" to the investigation, United
States v. Arthur Young & Co., 465 U.S. 805, 814, 104 S.Ct. 1495, 1501, 79
L.Ed.2d 826 (1984) (emphasis in original), and the applicable standard is
whether the information sought " 'might throw light upon the correctness of the
return.' " United States v. Egenberg, 443 F.2d 512, 515 (3d Cir.1971) (quoting
United States v. Harrington, 388 F.2d 520, 524 (2d Cir.1968)); see also LaMura
v. United States, 765 F.2d 974, 981 (11th Cir.1985); United States v.
Southwestern Bank & Trust Co., 693 F.2d 994, 996 (10th Cir.1982).
B. Delegation to Independent Auditors
48
The district court's power to entertain summons enforcement actions arises from
26 U.S.C. Sec. 7402(b), which reads as follows:
49any person is summoned under the internal revenue laws to appear, to testify, or to
If
produce books, papers, or other data, the district court of the United States for the
district in which such person resides or may be found shall have jurisdiction by
appropriate process to compel such attendance, testimony, or production of books,
papers, or other data.
50
It is clear that " 'an Internal Revenue Service summons can be enforced only by
the courts.' " Coopers & Lybrand, 550 F.2d at 620 (quoting Bisceglia, 420 U.S.
at 146, 95 S.Ct. 915, 43 L.Ed.2d 88). Nevertheless, courts often "farm out"
decision-making. Complicated factual disputes are routinely submitted to courtappointed experts under Fed.R.Evid. 706, to special masters under Fed.R.Civ.P.
53, to magistrates under 28 U.S.C. Sec. 636(b)(1)(B), and to court-annexed
arbitrators under 28 U.S.C. Secs. 651-58. However, in such cases the court
retains the ultimate decision-making authority. By leaving the relevancy
determination solely up to the independent auditor, the district court's actions
amounted to complete delegation, hence violating the mandate that courts
enforce IRS summonses.
51
support it. The task delegated to the independent auditors is surely outside the
scope of Fed.R.Evid. 706, which allows experts to render an opinion on the
facts of a case, but does not allow experts actually to decide the case.
Alternatively, Rule 53 (pertaining to Masters) may be employed "only upon a
showing that some exceptional circumstance requires it," Fed.R.Civ.P. 53(b),
and the Master's report must be reviewed by the court, Fed.R.Civ.P. 53(e)(2).
Nor to our knowledge would the independent auditors be certified as courtannexed arbitrators under 28 U.S.C. Secs. 651-58. We note generally that "
[e]ven in complex litigation, use of these procedures is the exception and not
the rule." Manual for Complex Litigation Second Sec. 21.5 (1985).
52
53
54
It is well-settled that the IRS's summons power is "not absolute and is limited
by the traditional privileges, including the attorney-client privilege." Upjohn
Co. v. United States, 449 U.S. 383, 398, 101 S.Ct. 677, 686, 66 L.Ed.2d 584
(1981). The burden of proving the defense falls upon the party resisting
enforcement of the summons. See Powell, 379 U.S. at 58, 85 S.Ct. at 255; El
Paso, 682 F.2d at 538. The privilege will apply as follows:
55
(1) Where legal advice of any kind is sought; (2) from a professional legal
advisor in his capacity as such; (3) the communications relating to that purpose;
(4) made in confidence; (5) by the client; (6) are at his instance permanently
protected; (7) from disclosure by himself or by the legal advisor; (8) except the
protection be waived.
56
57
The district court did not make factual findings supporting its disposition of the
attorney-client privilege issue. Rather, it stated only that, "in light of the Fifth
Circuit's finding in El Paso [that similar information was not shielded by the
attorney-client privilege], we find that the IRS is entitled to relevant portions of
the free reserve file." The flaw in the district court's approach is that it did not
find facts to support its ultimate legal determination.
58
The sine qua non of any claim of privilege is that the information sought to be
shielded is legal advice. Upon remand, if the relevancy test is met, the district
court must first determine whether the information in the free reserve file is
legal advice. The Fifth Circuit noted in El Paso that "the preparation of tax
returns is generally not legal advice within the scope of the privilege." El Paso,
682 F.2d at 539 (collecting cases). However, the El Paso court expressly
declined to rule on whether certain material collected in a free reserve file could
constitute legal advice, stating: "[W]e would be reluctant to hold that a lawyer's
analysis of the soft spots in a tax return and his judgments on the outcome of
litigation on it are not legal advice." Id.
59
Faced with the testimony of Mr. Stoops that Rockwell's free reserve file
contained exactly the kind of material referred to in the El Paso decision, we
hold that the district court must make specific factual findings as to the nature
of the material in the free reserve file in order to determine whether it
constituted legal advice for purposes of the privilege. Additionally, the district
court must determine who had control of the file, as well as who was involved
in its preparation. It is clear that the attorney-client privilege applies only to
communications between attorney and client; the Supreme Court has held that
there is no accountant-client privilege. See Arthur Young, 465 U.S. at 817-20,
104 S.Ct. at 1502-03.
60
that are intended to be disclosed to third parties or that in fact are so disclosed.
See United States v. Bump, 605 F.2d 548, 551 (10th Cir.1979). It has been held
that the disclosure of any meaningful part of a purportedly privileged
communication " 'waives the privilege as to the whole.' " El Paso, 682 F.2d at
538 (quoting United States v. Davis, 636 F.2d 1028, 1043 n. 18 (5th Cir.), cert.
denied, 454 U.S. 862, 102 S.Ct. 320, 70 L.Ed.2d 162 (1981)). But see United
States v. Upjohn Co., 600 F.2d 1223, 1227 n. 12 (6th Cir.1979) ("[T]he
corporation's voluntary disclosure to the SEC amounts to a waiver of the
privilege only with respect to the facts actually disclosed."), rev'd on other
grounds, 449 U.S. 383, 101 S.Ct. 677, 66 L.Ed.2d 584 (1981). As these cases
indicate, there is some disagreement as to what effect disclosure to independent
auditors (or the SEC) of information derived from a free reserve file will have
in determining whether the attorney-client privilege has been waived. Indeed,
there is factual disagreement in the case at bar as to what and how much of the
free reserve file was revealed by Rockwell to its independent auditors and the
SEC. If the district court reaches the issue upon remand, it will need to make
specific factfindings in this area to facilitate our review of a difficult question.5
61
62
The work product doctrine also may be asserted to defend against an IRS
summons. See Upjohn, 449 U.S. at 397, 101 S.Ct. at 686; El Paso, 682 F.2d at
542; United States v. Amerada Hess Corp., 619 F.2d 980, 987 (3d Cir.1980).6
The doctrine is designed to protect material prepared by an attorney acting for
his client in anticipation of litigation. See, e.g., In re Grand Jury Proceedings,
604 F.2d 798, 801 (3d Cir.1979). Federal Rule of Civil Procedure 26(b)(3)
makes clear, however, the necessity that the materials be prepared in
anticipation of litigation, and not " 'in the ordinary course of business, or
pursuant to public requirements unrelated to litigation.' " El Paso, 682 F.2d at
542 (citation omitted).
63
often a difficult factual matter. See id.; In re Grand Jury Investigation, 599 F.2d
1224, 1229 (3d Cir.1979). The test, as set forth in El Paso, is as follows: "
'[L]itigation need not be imminent ... as long as the primary motivating purpose
behind the creation of the document was to aid in possible future litigation.' " El
Paso, 682 F.2d at 542-43 (quoting Davis, 636 F.2d at 1040). The Third Circuit's
analogous standard, formulated in the grand jury context rather than in response
to an IRS summons, asks whether "in light of the nature of the document and
the factual situation in the particular case, the document can fairly be said to
have been prepared or obtained because of the prospect of litigation." In re
Grand Jury Proceedings, 604 F.2d at 803. Rockwell argues that the free reserve
file is maintained to "aid Rockwell in future negotiations and litigation with the
IRS." The government, on the other hand, contends that the file is maintained
so that Rockwell may comply with generally accepted accounting principles
and SEC reporting requirements. It will be necessary upon remand for the
district court to determine with specificity Rockwell's motivation in creating
and maintaining the free reserve file.
64
The district court must consider the other elements of the work product doctrine
as well. In this case, the most obvious question to arise is whether the
documents in the free reserve file were created by attorneys. Rockwell's tax
counsel, Charles Stoops, testified that he is solely responsible for the
maintenance of the file, and that the documents are prepared by him and by
accountants acting under his direct supervision. However, the district court
made no factual findings in this regard, and it must do so upon remand.
IV.
65
In summary, we conclude that the district court erred in limiting the scope of
the relevancy determination to the Chattanooga plant closing, as well as in
conditioning the enforcement of the summons on review by an independent
accounting firm. Consequently, we will vacate the order of the district court
and remand for further proceedings consistent with this opinion.
The free reserve file actually consists of three files with a combined thickness
of about twelve inches. App. at 191. The papers contained therein represent
Rockwell's analysis of the "soft spots" in its return. In preparing its tax return,
Rockwell, like all corporations, often is faced with situations in which the
application of the tax code is unclear. Tax counsel resolves the issue in one
manner, but records the possibility and consequences of an adverse ruling by
the IRS on that issue in the free reserve file. In this way, the corporation is able
to document any contingent liability that may befall it as a result of an adverse
tax ruling. Also included in the file are tax counsel's analyses as to the
likelihood of any adverse rulings, as well as various negotiation and settlement
positions
2
The Supreme Court recently discussed the issue in Arthur Young. Although
work product was rejected as a defense to an IRS summons in that case,
Rockwell's situation is distinguishable because the Court in Arthur Young
based its decision on Arthur Young and Company's position as independent
outside auditors for the Amerada Hess Corporation. The Court held that:
The Hickman work-product doctrine was founded upon the private attorney's
role as the client's confidential adviser and advocate, a loyal representative
whose duty it is to present the client's case in the most favorable possible light.
An independent certified public accountant performs a different role.... The
independent public accountant ... owes ultimate allegiance to the corporation's
creditors and stockholders, as well as to the investing public. This "public
watchdog" function demands that the accountant maintain total independence
from the client at all times and requires complete fidelity to the public trust. To
insulate from disclosure a certified public accountant's interpretations of the
client's financial statements would be to ignore the significance of the
accountant's role as a disinterested analyst charged with public obligations.
Arthur Young, 465 U.S. at 817-18, 104 S.Ct. at 1502-03.